In Schweser Book 5 page 326: Question 1 basically asks the question about the hedging instrument for the receiver interest rate swap. Honny enters into a swap to pay LIBOR while receiving the fixed rate annual pay plain vanilla swap for 2 years. The question reads: Which of the following would be the least appropriate hedging instrument for the 2 year plain vanilla swap postion that Honny plans to take? A. Interest rate call B. Interest rate future C. Forward agreement. Scheweser supplied answer is A. I don’t understand why… Could somebody help? My understanding here is if Honny pays LIBOR, he is worried about the prevailing interest rate will rise; so he is perfectly hedged if he buys the interest call. The answer says a combination of interest rate call / put would hedge the position. Don’t understand… Pls. help.
A call can partly do the hedge, when the Libor goes up. B andd C surely can help to fix the floating payment to a fixed level which will do a 100% hedge. Since it is mentioned in the question “least appropriate”, so I would go for A due to the incomplete hedge. On the other hand, Forward and Futures are nothing different concerning their effect on the payment, and this may help to leave A as the only choice.